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Volume 2, Issue 2

Deep Value

The Octavian Report: May 2016

Deep Value Vol 2, No 2 / The Octavian Report: May 2016

The Turning Tide

Flickr. There are glimmers of a possible turnaround for the beleaguered dry bulk sector.

Dry bulk shipping has run aground. The Baltic Dry Index is in freefall. Average carrier earnings are foundering, reaching in January a historic low of US$4,434 per day. There is a perfect storm going on. The single biggest driver of demand for iron ore and coal has cratered. A massive oversupply of vessels contracted in headier times is continuously putting keels to breakers. The past eighteen months have seen a string of big-name bankruptcies across the industry.

So yes, the current picture for the sector looks dispiriting. But there is still value to be found. The best cure for a low price is a low price, and as Baron Rothschild once remarked, “Buy when there’s blood in the streets.” We might add: or in the water. We believe that Diana Shipping (NYSE: DSX) is one of the best vessels for that value, a dry bulk play in strong hands with a nearly-immaculate balance sheet.

Diana started life in Athens in 1979 under the captaincy of Simeon Palios, who has remained in the CEO role since that time. Palios is a veteran of the Greek navy and has strong credentials in the shipping world. The company first listed in 2005 and rode the waves upward over the next three years as dry bulk was propelled by insatiable China demand for raw materials. When the sector started to fall apart, Diana, in a move that looks positively inspired, suspended its dividend in November 2008 and secured most of its fleet on time-charter contracts. This astute battening-down of the hatches allowed the company to weather the downturn that accelerated shortly thereafter. During a bounce in the sector, the company grew strategically — in the most abysmal market for dry bulk in years — while keeping its balance sheet strong. The company now operates a young (average age of 7.5 years) fleet of 43 ships, of which 23 are Panamax, four are Kamsarmax, three Post-Panamax, 14 are Capesize, and two are Newcastlemax.

In this historically depressed environment, a healthy balance sheet like Diana’s means a lot. Its management likes to call it a “fortress.” Compared to its peers in the industry, Diana looks less leveraged.With just over $367 million net debt, it can boast at current values a very solid debt-to-asset value ratio of .52, as opposed to much more highly levered peers like fellow Greek firm Navios Maritime Holdings at 1.55x. This is an artifact of the caution Diana displayed during the boom years and a sign, more broadly, of the management discipline the company has become known for. Diana also has less spot exposure than many peers, with some 64 percent of its fleet on time charter coverage through 2016, outstripping their closest competitor by almost six times and allowing for almost 100 percent fleet utilization during 2015. Indeed, the company has cash on hand of $193 million, which provides them precisely the kind of protection necessary to weather a market like this, where rates have been hovering well below average daily opex. Diana managed to keep costs almost flat over 2015 and — after an earnings miss in the last quarter due largely to several ships coming off charters and into a much-lower-rate market — booked an average $7,700 TCE rate for the first quarter of 2016, considerably better than the industry benchmark over the same period. Its forward capex picture looks modest, with just six vessels scheduled for delivery through 2016. Diana snapped up three at rock-bottom prices and full financing with a two-year no-amortization period that should provide them with a bit more cushion. So the rest of this year doesn’t hold any big-ticket items on that front to exert drag.

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Indeed, the hurdles Diana faces are all macro. As noted above, the macro picture for dry bulk has been horrific due to two big factors. The Chinese slowdown is well-known. Worse still are the ugly fundamentals of supply and demand. 2007 was a red-letter year for bulker shipbuilding, with some 170 million dwt contracted for — an increase of nearly 570 percent from 2005. Then came 2008, and the world turned upside down. But shipbuilding, ancient art that it is, moves at times far more slowly than market whipsawing. Which meant that actual deliveries of ships climbed precipitously during the very worst years of the crisis (though the actual tonnage delivered ended up taking a significant haircut from cancellations). As this was going on, distressed investors thought they spotted opportunity in the sector, pumping in liquidity and preventing supply from rationalizing. 2010 and 2013 saw two almost identical spikes in contracting, both at about the 100 million dwt level, helped by banks extending debt to avoid writedowns. (That bill is now starting to come due.) Thus the massive supply hangover from which dry bulk is still reeling like the proverbial drunken sailor.

So why Diana? Why now? There are signs of life amid all this darkness for the sector. On the oversupply issue, it seems that the painful medicine needed is being delivered. February saw the scrapping of a combined 6.7 million dwt; a 63 percent increase year on year — and demolition is forecasted to remain high throughout 2016. Capesize and Panamax ships are expected to see the smallest segment growth in fleet size over 2016, at 0 and 1 percent respectively, with Capesize expected to dip into fleet shrinkage by 2017. Owners, faced with the choice of putting ships due for maintenance into cold layup are scrapping rather than throwing good money after very, very bad. So fleet age has been trending younger, with the average age of demolition down seven percent year on year across all segments. This strong downward trend is visible very clearly in Panamax and Capesize ships, the backbone of Diana’s fleet. So this is a supply-side issue, and the worse it gets the faster it will improve. A squeeze is coming even if the Middle Kingdom commodity situation doesn’t heal but only stabilizes: remember, China consumes around one-third of the world’s raw materials. And because Panamax and Capesize ships see the most volatility in rates, they offer the most upside. If you play here, you might as well play to win.

There are, in other words, the first stirrings of life in dry bulk. And Diana seems poised to benefit from it, for all the reasons outlined above: its careful management team, its “fortress” balance sheet, and its young fleet. Our NPV analysis of its five-year DCF should day rates return to their 2010 levels — $20,000 for a Panamax and $31250 for a caper, and well below the sky-high rates of 2007, where a Panamax could command almost $50,000 a day and a caper almost $100,000 — suggests that there’s real value here. At a discount rate of 10 percent, the company’s current share price of $3.12 looks very cheap: our models predict per-share value from those improved cash flows could exceed $10. Not a real reach given that it changed hands above $13 as recently as March of 2014. Skinning the cat another way, Diana’s fleet, should valuations return to 2010 levels over the next five years, produces a per-share NAV of $9.70, still a multiple of more than three at current prices. That is based on a cautious set of assumptions, pegging, for example, the value of its newest and largest ships at $50 million when values for those builds climbed as high as $155 million in better times, and taking due note of the fact that Diana owns and operates a young fleet. If by some chance the dry-bulk sector claws its way back to the halcyon days before the global financial crisis over that same period, our fleet NAV per-share hits a mouthwatering $21.17, making this one a potential seven-bagger. And if Poseidon himself were to come to the sector’s aid and restore 2010 values in the next few months, Diana’s current vessels at their current ages produce an NAV of $27.49, almost 9x current prices.

Odysseus, the wiliest Greek in history and possessing the favor of an even-wilier god, still faced not one but many disasters at sea: shipwrecks, maelstroms, and the hideous monsters of the deep. The modern ocean trade may look a lot stabler, but now as in antiquity the risks involved in it are not for the faint of heart. The glimmers of hope for dry bulk just that — glimmers. At current rates of supply cutback, the glut still remains in the picture barring a massive upswing in scrapping or a huge contraction in orders. Diana’s balance sheet could help it hang in until the picture clears — unless it takes years and years. The company faces serious obstacles beyond that, as well. Mild accusations of impropriety have swirled around its CEO in the recent past: he ordered up three Panamax ships from companies owned in part by his relatives. (Though this is par for the course in the industry.) The volatility ofbigger ships cuts both ways, and Diana’s smallest draws almost 74,000 dwt. And though all prediction markets seem to suggest that Hillary Clinton will triumph against likely GOP presidential nominee Donald Trump, should he manage to claw his way into the White House one might expect chaos tn the global trade picture. Given that more than 90 percent of the world’s trade moves on ships, the aftershocks might be deadly to dry bulk.

That said, the sector looks like it has almost nowhere to go but up. And Diana, given its miserly burn rate over 2015 of $2.1 million a month, can afford to wait (at least for a while). It’s an intriguing bet on the industry’s future. So take heart: as Eugene O’Neill once wrote, the sea hates a coward.